The Political Origins of “Financialization” in the United States

• In Event: Financial Systems and Social Citizenship in American Political Economy

Abstract

When scholars write about the “financialization” of the US economy, what do they mean (Braun and Gabor 2020)? In short, financialization refers to the process in which the financial sector of the economy--organizations that provide capital based on expected returns--grows relative to other sectors (Krippner 2005). According to Greenwood and Sharfstein (2013), the US financial sector quintupled its value-added share of GDP in the last century--from 1% in the early 1940s to nearly 5% in 2009. Yet most scholars are pessimistic about this growth for the American economy at large (Philippon and Reshef 2013; Witko 2016). While Krippner (2011) locates the political foundations of financialization in the 1970s and 1980s, I argue that its origins occurred earlier, during the New Deal and World War II, in an internecine conflict within the Democratic Party over the sovereign bond market and how to fund war deficits. I propose a historical case study that utilizes process tracing, archival research, and quantitative analyses of roll-call votes using data from the 1940 census, to understand the politics of financialization in the US. I next provide a brief sketch of this conflict within the Democratic Party and its consequences for financialization.

One of the most pressing issues at the beginning of the US’ involvement in World War II was how to best finance the war. Increased taxes could cover some of the new government spending, but some money had to be borrowed. Yet who would the government borrow from? The Roosevelt administration favored volunteer bond purchases by citizens and corporations, instead of the commercial banking sector. This was because when commercial banks purchased securities, they paid for them on credit instead of with actual reserves, which could be inflationary. Furthermore, if banks came too close to dropping below their reserve requirement, they could use the purchased securities as collateral for money from the Federal Reserve, at almost 0 interest. As US Treasury bonds were seen as safe assets, they were very attractive to banks who could purchase large quantities and gain substantial interest payments at extremely low levels of risk. The tremendous scale of the war effort meant that there were too many bonds for the non-bank private sector to purchase on their own. With the Federal Reserve outlawed from directly purchasing bonds from the Treasury (only on the “open market”), the Treasury was forced to allow bank debt purchase. Banks purchased more government securities in one month (December 1942) than they had in a three year period from 1916 to 1919 (Whittlesey 1943). By 1943, commercial banks held over one-half of the US public debt.

To some policymakers this system was unacceptable, as from their perspective, the federal government was farming out its constitutional right to create money to banks and paying them for this service through interest. One such Congressman, Wright Patman (D-TX), favored a different form of financing the war. Instead of having commercial banks purchase leftover bonds, Patman argued that the Federal Reserve System, as it had before 1935, should be allowed to directly purchase bonds from the Treasury, and that, in an effort to reduce future taxpayer burden, those bonds should not bear interest. A version of this proposal was adopted, though for different reasons. In 1942, at the behest of Federal Reserve officials (most notably Chairman of the Fed Marriner Eccles)--Congress authorized the Federal Reserve to purchase at maximum $5 billion of bonds direct from the Treasury at negotiated rates instead of solely on the open market. While controversial, Eccles defended direct purchasing as essential to the smooth functioning of the Treasury market during war and denied that it would be any more inflationary than Fed purchases on the open market, saying:

“Nothing constructive would be accomplished by the proviso that the Reserve System must purchase Government securities exclusively in the open market. About all that such a ban means is that in making such purchases a commission has to be paid to Government bond dealers…. it is an illusion to think that to eliminate or to restrict the direct-borrowing reduces the amount of deficit financing. Or that the market controls the interest rate. Neither is true” (Congress 1947).

Eccles acknowledged that the existing system of financing government debt had costs--including a “commission” being paid to banks--with few benefits. Yet Patman’s insistence that the program be expanded and made permanent was ignored. While profits on interest gained by the Reserve System were taxed away starting in 1946, that did not occur for commercial banks. From 1940 to 1945, despite low interest rates, commercial bank profits doubled, with most of the increase coming from dividends from securities (Seligman 1946). Interest rates, bank profits, and the financialization of the US economy only increased from then on.

Author

• David Martin, Rutgers University, New Brunswick